Question

Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its early years to provide it with at least eight years of tax loss carryforwards. Thus, Quartz’s effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term of the lease is five years. The purchase cost of the equipment is $890,000. New Leasing Company is in the 35 percent tax bracket. There are no transaction costs to the lease. Each firm can borrow at 12 percent.

a.	What is Quartz’s reservation price? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Reservation price

$

b.	What is New Leasing Company’s reservation price? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Reservation price

$

Answer 1

Part a)

The reservation price for Quartz can be calculated with the use of PMT (Payment) function/formula of EXCEL/Financial Calculator. The function/formula for PMT is PMT(Rate,Nper,-PV,FV) where Rate = Interest Rate (here, borrowing rate), Nper = Period, PV = Present Value and FV = Future Value (if any).

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Here, Rate = 12%, Nper = 5, PV = $890,000 and FV = 0

Using these values in the above function/formula for PMT, we get,

Quartz's Reservation Price = PMT(12%,5,-890000,0) = $246,894.66 (answer for Part a)

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Part b)

The New Leasing Company’s reservation price can be calculated with the use of following equation:

NPV = 0 = -Cost of Machine + Reservation Price*(1-Tax Rate)*[PVIFA(Rate,Years)] + Depreciation Tax Shield*PVIFA(Rate,Years)

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Here, Cost of Machine = $890,000, Rate = 12%*(1-35%) = 7.80% and Depreciation Tax Shield = 890,000/5*35% = $62,300

Using these values in the above equation, we get,

NPV = 0 = -890,000 + Reservation Price*(1-35%)[PVIFA(7.80%,5)] + 62,300*PVIFA(7.80%,5)

NPV = 0 = -890,000 + Reservation Price*65%*4.01385 + 62,300*4.01385

Solving further, we get,

Reservation Price = (890,000 - 250,062.57)/2.609 = $245,280.77 (answer for Part b)

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Notes:

PVIFA indicates Present Value Interest Factor for an Annuity.